How The Euro Exploded, Part 1

Berlusconi-comizio
"I have no idea what I'm doing!"

Italian stock markets rally on rumours that Berlusconi may step down. That says everything really. Usually the forced resignation of a head of government sends the markets plummeting, as a country switches from general predictability into leaderless chaos. But it seems even leaderless chaos would be more relaxing than Silvio Berlusconi. You can actually calculate the millions he’s costing his country every minute he hangs on.

If he does go though, he will be the third national leader directly forced out by the financial crisis. I don’t think there’s been such a wave of regime change across Western Europe since 1968. How did it come to this – and to ask the question that everyone really wants answered, whose fault is it?

You can’t pinpoint a single cause in these things of course, but surprisingly I think we can narrow it down to just three:

Problem one: The credit boom. We’ve spoken of this before, but its origins can be traced back to the liberalisation of the US banking industry, and the creativity this consequently introduced into a previously staid profession. In particular, the creativity about what the term ‘asset’ means.

It’s always been quite acceptable to loan someone some money and then consider their promise to pay you back as an asset you own – as long as the value you give to that asset realistically reflects the risk of them not paying you back at all. Be unrealistic however, and you’re in trouble. Though many complex and obscure mechanisms were applied to the task, I don’t think it’s grossly oversimplifying to say the basic problem was that overvalued loans were used as collateral to raise more money, which was then turned into more overvalued loans, which were used to raise more money, which was… Et voilà, magic money from nowhere. Inevitably this reached the point where it was mutually profitable for everyone involved to overvalue the loans they were all giving to each other.

This free money fountain naturally encouraged borrowing throughout the US and Europe, and indeed about everywhere with access to currency markets. The first I knew something had gone badly wrong was when I got a letter from my bank telling me I’d been ‘pre-approved’ for a loan I hadn’t asked for. I’m a freelance artist for God’s sake. When banks go round pushing loans on poor people, the Emperor is out waving his dangly bits to a cheering audience.

But it wasn’t just private borrowing that got out of control. Countries too found credit temptingly cheap. What’s more, easy credit helped fuel a consumption boom, which upped tax revenues, which encouraged governments to ease off rates and make more promises. The problem is that largely fictitious revenues can dematerialise overnight.  Public borrowings and spending commitments on the other hand are not so easily gotten rid of.

This though merely sets the global scene; in Europe specifically there was further trouble brewing. To follow…

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2 thoughts on “How The Euro Exploded, Part 1

  1. I have recently come across a (pdf) version of events that traces the credit boom to China. Key quotes:

    In a world where the dollar is the de facto reserve currency, a net foreign liquidity demand necessarily implies a commensurate increase in the US current account deficit.

    and

    These massive inflows of international reserves from emerging economies like China
    were largely insensitive to interest rates and put downward pressure on real interest rates
    across the maturity spectrum despite widening US current account deficits.

    In other words, when private entities buy US public debt they must be enticed by the interest rates. When sovereign nations buy US public debt to strengthen their position they don’t care about interest rates that much. This drives interest rates down. When a player like China enters this market interest rates remain low despite the fact that the US grows fast. Low rates equals cheap money across the whole board. People are then tempted to borrow money and invest it in anything that may promise to pay more. Couple that with the deregulation that allowed investment banks to reach into previously restricted areas and you have the makings of a global pop.

    Like

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